Hope and Optimism II

New York City -- Is the economy better?  Not quite, but two things I have urged since the crisis began came to pass last week, and the results were positive.  Last Thursday, the House finally held a hearing on easing mark-to-market rules.  The prospect of the hearing lifted markets at the beginning of the week and the result of the hearing, a consensus to tweak FAS 157 -- a regulation introduced at the beginning of the crisis -- lifted them into the weekend.  Leaked news of profits by Citi and other banks, meaningful only if mark-to-market losses do not occur, fed the rally.  As I also urged, the Obama Administration took the occasion of the market's rise to launch a confidence offensive, culminating in a rare 60 Minutes appearance Sunday night by Fed Chairman Bernanke in which the Chairman expressed cautious optimism that things are improving.  Confidence by leaders is critical to recovery because without it, one cannot expect the public to be hopeful or resume buying.

Does that mean the worst is over?  As Fed Chairman Bernanke noted last night, the answer is entirely dependent on reviving the banks and here, the task is harder.  The key element to reviving the banks, I have argued, is finding a way to transfer impaired assets off their books without having to price those assets in the midst of a fire.  Currently, banks won't sell at fire sale prices, as this would make them insolvent, while investors won't buy at anything above fire sale prices after the brutal losses some incurred last fall.  The Treasury hopes to bridge the huge bid-asked divide through a combination of lending private investors the money to buy assets and guaranteeing any losses. This remains a complex plan, the uncertain terms of which have stalled action.

There is really only one answer to the problem of pricing assets during a fire: put off pricing or indeed selling them until the fire is out.  In other words, to make the transfer efficient and minimally painful to taxpayers, as with the RTC which worked so well in the 1990s, the bad assets must be unloaded over time.

The only players able to front money for the assets without pricing them are the Fed, using its balance sheet, or the Treasury, using its guaranty power.  Either can take custody of the impaired assets in exchange for instant credits to the banks.  The Fed or Treasury-guaranteed entity could then sell off the assets over time as China did at the beginning of the decade.  While taxpayers would eventually incur losses, these are minimized by selling the assets off in orderly fashion and could be further reduced through warrants.

Of course, popular anger over the AIG bonus announcement makes decisive action more difficult than ever.   At the end of the day, however, a time shift that gives the banks credits now for assets that can be sold off over time is the best scenario for recovery in the near rather than the long term.